The gold price stabilized at $1,065 as the U.S. dollar strength that has pressured the price of gold over the past ten weeks subsided. Gold mining stocks, suffering a 29% correction as measured by the Market Vectors Gold Mining ETF (GDX) since early December, showed signs that a new uptrend could be underway. After displaying significant relative weakness versus gold bullion over the course of the past eight weeks, the shares of gold mining producers rallied strongly Friday afternoon in response to a late day surge in the gold price.

Risk aversion accelerated last week, prompting an unwinding of carry trades and leading to rallies in both the U.S. dollar and the Japanese Yen. Unsettled by sovereign debt worries in the region, the euro has been under pressure, falling 1.5% last week versus the U.S. dollar and an even steeper 2.8% against the Japanese yen. The U.S. Dollar Index (DXY) rose to its highest level in seven months, climbing 1% over the course of last week, hitting its highest level since last July.

Borrowed dollars and yen, which financed the purchase of higher-yielding and riskier assets, were bought back and the acquired investments were liquidated. Global stock markets tumbled with the weak European economies plagued by sovereign debt concerns suffering the steepest declines. Last week, Portugal’s PSI 20, Spain’s Ibex, and Greece’s General benchmark indices were pummeled 7.2%, 7.7%, and 8.3% respectively. The S&P 500 held up relatively well, losing only 0.7% after Thursday’s precipitous drop, which sent U.S. stocks to their largest one-day decline since April of 2009.

Commodities fell as confidence waned, punctuated by a 6.5% decline in the price of copper. West Texas Intermediate Crude Oil futures lost 2.3% last week, bringing their 2010 decline to 11%. Waning risk appetites pressured the commodity currencies, with the Australian dollar dropping 2.4% versus its U.S. counterpart.

Confidence, albeit difficult to measure, is perhaps the most crucial variable facing both the global economy as well as global stock and commodity markets. Greece’s Prime Minister, George Papandreou, announcement that higher fuel taxes and public sector pay cuts would be implemented sent shivers through his nation. While necessary to bring down his country’s spiraling budget deficit, such medicine is likely to cause deeper hardship in the near-term. The Greek dilemma is one facing not only Spain and Portugal, but also Japan and the United States.

With unemployment showing no sign of a meaningful decline and the economic backdrop still challenging, the concept of fiscal austerity in such an environment will not be popular with the citizenry. Will politicians and central bankers implement policies that could cause short-term pain in return for a more stable, healthy longer-term global economy? Early indications are a resounding “No.” The Economist called President Obama’s budget proposal “a road map to fiscal catastrophe.”

This weekend’s G7 meeting resulted in broad-based support for a continuation of the general theme of prioritizing the prevention a double-dip recession at the expense of rising deficits and debts. The recent troubles in Europe and the correction in global equity markets have heighted deflation worries - and world leaders, many facing low popularity ratings, are giving the people what they demand.

The current deflation scare has caused a spike in volatility and sent asset prices lower across the board. The gold price has suffered amidst the selling pressure - from both the unwinding of dollar carry trades and the perception that a falling euro/U.S. dollar exchange rate is bearish for gold. During the depths of the credit crisis, the gold price and gold mining stocks were liquidated alongside broader equities and commodities - and the same phenomenon has occurred in recent weeks. Correlations amongst gold and other investment classes has been exceedingly high over the past year and if risk aversion continues to rise and a deeper correction in global stock markets ensues, then the gold price and gold stocks could be expected to fall further.

However, the longer-term implication of free-spending, reckless governments is bullish for the gold price. Private sector de-leveraging has been replaced by a massive infusion of public sector deficit spending. Just as Bear Stearns was a warning signal for Lehman Brothers -which was a warning signal for Merrill Lynch and the rest of banking behemoths - Dubai was a prelude to Greece. Greece is very likely not the last nation to see investor confidence flee. Unfortunately, larger sovereign debt crises down the road appear to be a foregone conclusion with both Japan and the United States at risk. Whether the objective is to finance war or placate its citizenry during times of economic stress, public sector deficit spending and currency inflation have been one of the few constants for thousands of years.

This irresistible policy prescription temporarily alleviates the suffering. However, over a longer time frame, money supply expansions inevitably spiral out of control and lead to an eventual painful readjustment that results in a lower standard of living. Moody’s recent warning on the triple-A credit rating of the U.S. serves as a prelude of further trouble for the U.S. dollar down the road. Gold serves as protection from the recklessness of politicians and central bankers who cannot resist the desire to inflate away today’s problems and push them off to a later date. While the gold price can be expected to remain volatile, the emergence of sovereign debt concerns is likely the final pillar in gold’s re-emergence as a monetary alternative.